As chip stocks bounce back, some see opportunities

James P. MillerTribune staff reporter

A summer sell-off in the volatile semiconductor group has raised an interesting question for investors: If the chips are down this much, is it time to buy?

Although semiconductor stocks have underperformed the broader market since May, in recent weeks the market appears to be regaining an appetite for the group. Shares of computer chip-makers such as Intel Corp., Advanced Micro Devices Inc. and National Semiconductor Corp. have not only halted their earlier nose dive but also regained a good portion of the ground they lost.

A number of experts are suggesting that chip-industry investors overreacted to recent evidence of the economy's slowdown. And by doing so, they say, the sell-off may have created some opportunities in individual chip stocks, or in exchange-traded funds based on semiconductor-makers.

Overall, the market has "probably been a bit too negative" on the chip sector during the summer months, Needham & Co. analyst Charlie Glavin said. Needham is "cautiously optimistic" on the sector, Glavin said, and while chip stocks as a whole are not cheap, a number have been oversold and "we're telling people to buy if they can find opportunities and be selective."

The upside potential hasn't escaped private-equity investors, even though they have long avoided chip companies because of the sector's substantial swings in profitability. Earlier this month, a leveraged-buyout group agreed to pay $17.6 billion to acquire Freescale Semiconductor Inc. in what not only is the tech world's biggest-ever LBO, but also is evidence that deep-pocketed investors are cruising the chip world in search of bargains.

A number of observers still fret about the increase in the inventory of unsold chips on hand, however, and the question whether the buildup is evidence of eroding fundamentals or a temporary slippage has yet to be answered.

Chip stocks may be moving away from their reputation as a sector that's not for the faint of heart. A recent trend toward outsourcing of production has helped dampen the industry's lowest lows, but also its highest highs.

More significantly, as computer chips penetrate ever deeper into consumers' everyday lives, companies' revenue streams are becoming more stable, more predictable, and, as a result, appealing to a broader group of investors.

Investors also are looking at companies that supply the chip industry, both as investing vehicles and as a source of clues about demand for chips. Chip stocks jumped this month, for example, after Credit Suisse First Boston analysts upgraded companies that manufacture semiconductor-making equipment. Chipmakers' need for such "fabrication" equipment is strengthening in part because demand for memory chips is proving more robust than expected, according to the report.

Some companies are looking to become leaner.

Earlier this month Intel--which is locked in a scorched-earth competition for market share with archrival Advanced Micro Devices Inc.--disclosed plans to eliminate more than 10,000 jobs as part of an efficiency plan aimed at reducing expenses by $2 billion in the coming year. Experts cannot agree whether the shake-up is evidence that the nation's leading chipmaker is floundering, or, alternatively, that the Silicon Valley icon is getting back in fighting trim.

The tech sector as a whole has enjoyed a rebound, said Harris Bank chief investment officer Jack Ablin, but Harris still rates the group "unattractive" for investors. Tech is not only sensitive to the economy, noted Ablin, but its players "enjoy no pricing power." Tech shares "have become the yin and yang of the stock market," Ablin suggested, with the one falling when the other rises.

The gains of the tech sector over the past six weeks, and of the chip sector that is a key component of tech, he said, very likely "reflect the energy decline," rather than strengthening tech fundamentals. "I'm going to need more evidence before I decide this move by tech is for real," he said, though he concedes that the sector is likely to strengthen by early next year.

For an investor the computer-chip world can be daunting, with its obscure acronyms, its history of overpromising, and its perpetual obsession with the next big thing. Even highly successful chip products have relatively short lifespans before they become obsolete, and industry players must perpetually pour money into product development.

At a fundamental level, however, the chip industry can be seen as a cyclical play, with its fortunes tracking the rise and fall of the broader economy.

Chips are deeply embedded in most aspects of modern life, from consumer electronics to transportation and heavy manufacturing. That has rendered the sector increasingly economically sensitive. Chip stocks are affected much more than they once were by real-world factors such as interest rates, the strength of the auto market, consumer debt levels and even the success of retailers' holiday seasons.

CIBC World Markets analysts recently reiterated their "market weight" position on the semiconductor group, saying that moderating economic growth and growing consumer caution will present a financial "headwind" for producers.

Indeed, many investors turned cool toward chip manufacturers early in the summer because the inventory of unsold chips had begun building up. So far the overhang generally reflects weakening demand from specific end markets, including personal computer and DVD manufacturers.

But if the economy continues to lose momentum, demand for chips could flag across a much broader spectrum. In that case, excess capacity could swiftly put downward pressure on chip prices--and thus on industry profit margins--in the year ahead.

In the giddiest days of the dot-com bubble the 19-stock Philadelphia Stock Exchange Semiconductor Sector Index soared upward and briefly topped 1300, only to drop by more than 80 percent when the tech bubble burst. The industry barometer has strengthened from its worst postbubble lows, however, and in May of last year began a major upturn.

From slightly below 400 the index climbed nearly 40 percent in less than a year. But the index went into a sharp tumble in May and by late July had bottomed out at about 385.

Since then the index has climbed back somewhat, but still has underperformed the broader Standard & Poor's 500 since the May high.

The sell-off was so broad and all inclusive, Morningstar Inc. analyst Larry Cao told investors as the selling eased in late July, that in some cases "the market has thrown out the baby with the bath water."

CIBC's tech analysts made the same point, saying "there were many quality names that were excessively punished during the summer." Such indiscriminate selling has "created opportunities in names where fundamentals remain sound," the report says, including such companies as Microsemi Corp. and Maxim Integrated Products Inc.

Individual chip stocks have individual dynamics. Many investors prefer to invest in the sector through options contracts based on the Philadelphia semiconductor index, or via semiconductor exchange-traded funds such as the SPDR Semiconductor ETF, which is based on the S&P Semiconductor Select Industry Index.

Other investors may prefer a Merrill Lynch-created sector-benchmark security known as the Semiconductor Holders Trust, which bundles together a portfolio of stocks in the chip sector.